Staving off a fiscal crisis in Japan

Credit ratings agencies play a significant role in whether or not a company — or a country — falls into fiscal catastrophe. For now, they’re all leaving Japan alone.

The three largest credit rating agencies have said that it’s too early to decide whether the recent earthquake will lead to downgrades for Japanese sovereign debt. Fitch rates Japan AA, S&P AA-, and Moody’s Aa2 and all three will remain unchanged for now.

The announcements may help keep a debt crisis at bay in Japan, as the country grapples with the mounting problems created by the last week’s series of natural disasters.

Workers are fighting to prevent a nuclear meltdown, the death toll is rising, and energy and food shortages are rippling across the nation. Moody’s notes that Prime Minister Kan was quoted in the Nikkei News as saying that the earthquake and tsunami created “the biggest crisis facing the country since World War II.”

“The shock from Friday’s earthquake does not make a fiscal crisis in Japan imminent,” Moody’s wrote in its recent report, a sentiment echoed by Fitch and S&P. “We recognize that the immediate focus of the government must be on emergency relief and reconstruction efforts, no matter what the fiscal cost.”

Before the earthquake, some hedge funds had wagered on a Japanese financial collapse, saying that the country would have to default on its massive debt (predicted to hit 228% of GDP this year) or destroy the value of the yen. In the past week, the debate about Japan’s fiscal health has returned, with Japan bears pointing to the fact that the government will be forced to borrow even more money to pay for rescue and reconstruction work.

Any downgrade of Japanese sovereign debt would certainly increase the likelihood of a debt crisis. While the agencies are adamant that their ratings are mere opinions, ratings often dictate whether large institutional investors can hold a bond (or must be forced to sell). Downgrades can also be trigger events in financial contracts, like credit default swaps, that force money to change hands between parties; and they have historically spooked markets. The decision to downgrade AIG (AIG) amid the financial crisis is a perfect example of a rating action having a real and disastrous impact.

In the case of Japan, the agencies all say that they have faith in the country’s ability to raise money as needed, and will take no action in the near term. They add that reconstruction will create future economic activity that could offset those borrowing costs.

Fitch warns that the rapid increase in the public debt burden will make it that much more important for Japan to come up with a credible plan to balance the budget and deal with its debt load. Fitch added that it would consider putting the country on negative watch if a “sustained rise in [Japanese Government Bond] yields… worsened the sovereign’s debt dynamics.” Because Japan has such a large debt, it can’t afford even a small rise in interest payments.

Moody’s agrees, saying that “a tipping point may be reached” if the market starts to sell JGBs and yields rise.

However, Japan has long borrowed money from its own people and institutions, which has kept interest rates low and markets stable. S&P believes that the country will continue to be able to issue additional debt “without a major increase in risk premiums, and does not expect major capital outflows.